Thursday, 2 December 2010

Europa Endlos

One exercise that I used to do quite often, back in the days when I was a "professional" trader (that is to say, a trader with other people's money), was to make up improbable scenarios and justify / explain them.

Part of my motivation for this exercise was to be intentionally and deliberately contrarian. Saying No when the market says Yes is a long-term profitable strategy in itself, irrespective of the underlying fundamentals. (Some day I will write a longer post on why this should be the case).

Another part of my motivation was to have fun. There's nothing like donning a tin-foil hat to enliven a drab afternoon trading session.

But the most important part of my motivation was a serious one: to avoid confirmation bias. Quoting Wikipedia: "Confirmation bias is the tendency for people to favor information that confirms their preconceptions or hypotheses, regardless of whether the information is true."

This was something I had to constantly guard against in my career as a trader. Given the sheer volume of market data that I was constantly barraged by, and the necessity of somehow filtering that data, it was essential to make sure that my filters were unbiased. Considering alternative points of view not tainted by a priori estimates of "probability" was an excellent way of maintaining filter neutrality. Hence the contrarian game.

Here's an example of how to play. Right now the newspapers are full of the Irish bailout and the fear of contagion in other Eurozone economies ("PIIGS-hooey"). You might think that this somewhat fraught state of affairs would lead to a decline in the Euro, and indeed that is the consensus opinion. So your task is to be contrarian and invent a rationale for going long the Euro, despite (or perhaps because of) these macro currents.

And here's such a rationale. Assume the crisis gets worse. Assume contagion in the form of inexorably rising bond yields spreads to Portugal, then Spain, then Italy. The worse the crisis gets, the less possible it is for the centre to bail out the periphery. The only option left is default, and possibly exit. But what happens after that? As successive dominoes fall, the common currency zone shrinks until only healthy core countries (read: Germany) remain. The Euro ends up looking a lot like the old Deutsche Mark. Freed of all its baggage, it begins to rally. Voila!

Note that I don't actually believe this scenario will eventuate, at least not with a high probability and not in the near term. But at the very least, thinking through a scenario like this (replete with path-dependency and feedback effects) makes it difficult to simple say "Europe in crisis, Euro goes down" and use that as a guide to trading. Life is more complicated than that.